We are considering a majority recapitalization with a financial sponsor who is using a high level of debt leverage to fund the purchase. How do we evaluate the risk of this debt on our rolled-over equity, and what veto rights do we need in the operating agreement to protect our minority share?

Question

Tyler Smith · Accepted Answer

A financial sponsor uses debt leverage to maximize their return on equity, but too much debt can choke your remaining minority share. If the company struggles post-close, the senior bank debt must be paid first, which can wipe out the value of your rolled-over equity.

To evaluate this risk, review the proposed leverage ratio. A safe debt load is typically defined as a multiple of your historical adjusted EBITDA, not your projected earnings. Ask for a pro-forma model that shows the company can comfortably service the debt even if revenue drops by fifteen percent.

Next, you must negotiate specific protective provisions and veto rights in the new operating agreement. As a minority shareholder, you need the right to veto certain actions that could dilute your equity or increase your risk. These veto rights must include:

- Incurring additional debt beyond the agreed-upon leverage ratio at close.
- Changing the primary line of business or entering highly speculative markets.
- Approving transactions with affiliates of the financial sponsor that could siphon cash out of the operating entity.
- Changing the distribution policy in a way that prevents tax distributions to cover your pass-through tax liability.

Protecting your rolled-over equity is just as important as the cash you take off the table today. Use your veto rights to ensure the sponsor cannot leverage the company into bankruptcy while chasing aggressive growth.